CFA Institute CFA Institute Certifications CFA-LEVEL-1 Questions & Answers

• Question 951:

  Which of the following methods for measuring "stand-alone" risk is characterized by the formulation of a "best case" and "worst case" scenario?

  A. Monte Carlo Simulation

  B. None of these answers

  C. Miller and Thorn Simulation

  D. Sensitivity Analysis

  E. Tributary Leads Analysis

  F. Probability Analysis

  Correct Answer: B

  The answer prompted in this question is "Scenario Analysis." Scenario Analysis is a method of measuring a project's stand-alone risk. This method is considered as superior to Sensitivity Analysis, and this is primarily because Scenario Analysis considers a range of possible values for the input values whereas Sensitivity Analysis considers only the sensitivity of the project's NPV to fluctuations in the underlying input variable(s). In Scenario Analysis, the financial analyst establishes a "worst case" and "best case" situation, in addition to the "base case." The base case scenario sets all the input variables at their most likely values. Often, the values used for the base case scenario are the current values for input variables or their expected values into the near future. In Scenario Analysis, the best and worst case scenarios are compared to the base case, and the sensitivity of the project's NPV is examined. "Tributary Leads Analysis," along with "Miller and Thorn Simulation," are completely fictitious answers.

• Question 952:

  Interest payments should be ________ the project cash inflows.

  A. added to

  B. subtracted from

  C. ignored while estimating

  D. subtracted from or ignored while estimating

  Correct Answer: C

  The effects of debt financing are taken into account through the discount rate used to discount the project cash flows. Hence, interest payments must be ignored while estimating a project's cash flows.

• Question 953:

  Which of the following statements is most correct?

  A. All of these statements are true.

  B. As a firm's debt ratio approaches 100 percent, the after-tax cost of debt, k(d)(1 - T) (after-tax component cost of debt, where T is the firm's marginal tax rate), will be at its lowest level.

  C. All of these statements are false.

  D. An increase in the corporate tax rate would lower the weighted average cost of capital for an average firm, other things held constant.

  E. Depreciation-generated funds have a cost equal to the firm's lowest WACC (Weighted Average Cost of Capital), and hence they have no impact on the MCC (Marginal Cost of Capital) schedule.

  Correct Answer: D

  Increasing the corporate tax rate would lower the after-tax component cost of debt, thereby lowering the WACC, with all other things held constant.

• Question 954:

  Effects of a project on cash flows in other parts of the firm is known as which of the following terms?

  A. Cannibalization

  B. Sunk Cost

  C. Incremental Cash Flow

  D. Opportunity Cost

  E. Externality

  Correct Answer: E

  Externalities are defined as effects of a project on cash flows in other parts of the firm

• Question 955:

  Which of the following are factors in the optimal dividend payout ratio?

  I. Investor's preference for dividends versus capital gains

  II. The target capital structure

  III. The investment opportunities available to the firm

  IV.

  The cost and availability of external financing

  V.

  Beta Coefficient

  A.

  I, II, III

  B.

  I, III, III, V

  C.

  II, III, IV

  D.

  None of these answers

  E.

  I, II, III, IV

  F.

  I, II, III, IV, V

  Correct Answer: E

  The optimal payout ratio of a firm represents the ideal amount of earnings that should be distributed to shareholders as dividends. This figure is comprised of four components, namely: the cost and availability of external financing, the investment opportunities available to the firm, the firm's target capital structure, and investor preferences. The Beta coefficient is not expressly incorporated into the determination of the Optimal Dividend Payout Ratio.

• Question 956:

  Clay Industries, a large industrial firm, is examining its capital structure. The firm is financed according to

  the following schedule based on market values:

  50% debt

  40% common stock

  10% perpetual preferred stock

  Additionally, consider the following information:

  Yield on outstanding debt: 8.50%

  Tax rate: 35%

  Annual preferred dividend: $2.55

  Preferred stock price: $25.97

  Return on equity: 16.75%

  Dividend payout ratio: 50%

  Cost of common stock: 14.25%

  Using this information, what is the Weighted Average Cost of Capital for Clay Industries?

  A. 8.97%

  B. 9.37%

  C. 9.45%

  D. 9.25%

  E. 9.37%

  F. None of these answers

  Correct Answer: C

  In order to calculate the WACC, it is necessary to first calculate the component after-tax cost of debt,

  common equity, and preferred equity. Once the cost of these components is determined, they are imputed

  into the WACC equation, which is as follows:

  {WACC = [(% weight of debt securities * cost of debt) + (% weight of common stock * cost of common

  stock) + (% weight of preferred stock * cost of preferred stock)]} To calculate the component cost of debt,

  use the following equation:

  {After-tax cost of debt = [yield on outstanding debt securities * (1 - tax rate)}

  Factoring in the given information into this equation would yield the following:

  {After-tax cost of debt = [8.50% * (1 - 0.35%)]} = 5.525%

  To calculate the component cost of outstanding preferred stock, the following equation must be used:

  {Cost of preferred stock = [annual dividend / preferred stock price]}

  {Cost of preferred stock - = [$2.55 / $25.97]} = 9.82%.

  The final component of the WACC calculation, the cost of common equity, has been provided as 14.25%.

  Now that the after-tax cost of debt, preferred stock, and common stock have been determined, the WACC

  calculation can be found. The calculation of the WACC is as follows:

  {[0.50 * 0.05525] + [0.40 * 0.1425] + [0.10 * 0.0982]} = 9.445%

• Question 957:

  A financial analyst with Mally, Feasance and Company is examining shares of a large specialty retailer.

  Assume the following information:

  EPS: $2.30

  ROE: 16.25%

  Growth rate of dividends: 12.00%

  Discount rate: 13.33%

  Tax Rate 35%

  Using this information, what is the dividend payout ratio for this specialty retailer? Further, what is the

  annual dividend?

  A. 73.85% $1.70

  B. 23.07%, $0.53

  C. 26.15%, $0.60

  D. 26.15%, $1.70

  E. 65.16%, $1.50

  F. 73.85%, $0.60

  Correct Answer: C

  To determine the dividend payout ratio, the equation used to determine the growth rate of dividends must be manipulated. This equation is originally structured as follows: {g = ROE (1 - Dividend Payout Ratio)} In order to determine the Dividend Payout Ratio, the equation must be rearranged to the following: {(1 Dividend Payout Ratio) = Growth Rate of Dividends / ROE}. Imputing the given information into this equation will yield: {(1 - Dividend Payout Ratio) = 0.12/0.1625)} = 0.73846 Finally, subtracting this figure from 1 will yield the answer of 26.15%. We must subtract the first answer from one because the first answer represents the retention rate, i.e. the percentage of earnings that is retained and reinvested at the firm's ROE. The retention rate and the payout ratio will always combine to equal positive one. In order to determine the annual dividend, take the Dividend Payout Ratio, which was found to be 26.15%, and multiply this figure by the Earnings Per Share calculation, which is given as $2.30. This will yield an annual dividend of $0.60154. As you can see, neither the discount rate nor the tax rate is factored into the equation.

• Question 958:

  If the calculated NPV is negative, then which of the following must be true? The discount rate used is ________.

  A. equal to the internal rate of return

  B. too high

  C. greater than the internal rate of return

  D. too low

  E. less than the internal rate of return

  Correct Answer: C

  If a project has a positive NPV, then it is generating more cash than is needed to service its debt and to provide the required return to shareholders, and this excess cash accrues solely to the firm stockholders. On the other hand is a project has a negative NPV, the required rate of return is not being met and the discount rate used must be greater.

• Question 959:

  The Congress Company has identified two methods for producing playing cards. One method involves using a machine having a fixed cost of $10,000 and variable costs of $1.00 per deck of cards. The other method would use a less expensive machine (fixed cost = $5,000), but it would require greater variable costs ($1.50 per deck of cards). If the selling price per deck of cards will be the same under each method, at what level of output will the two methods produce the same net operating income?

  A. 15,000 decks

  B. 20,000 decks

  C. 25,000 decks

  D. 10,000 decks

  E. 5,000 decks

  Correct Answer: D

  Total cost(Method 1) = $1.00(Q) + $10,000.

  Total cost(Method 2) = $1.50(Q) + $5,000.

  Set equal and solve for Q: Q + $10,000 = $1.50(Q) + $5,000

  $5,000 = $0.5(Q)

  10,000 = Q.

• Question 960:

  Ace Consulting, a corporate finance consulting firm, is examining the operating performance and asset structure of Clay Industries. In their analysis, Ace has identified the following information for the most recent reporting period: EBIT $500,590 Sales $988,000 Interest paid $40,800 Given this information, what is the Degree of Financial Leverage for Clay Industries?

  A. 0.567

  B. 0.465

  C. 1.974

  D. None of these answers is correct.

  E. The Degree of Financial Leverage cannot be calculated from the information provided.

  F. 2.149

  Correct Answer: D

  To calculate the DFL, the financial analyst needs to determine the EBIT and interest paid for a predetermined time period. To calculate the Degree of Financial Leverage, the following equation is used: {EBIT/[EBIT - interest paid]}. Incorporating the given information into this equation yields the following: {$500,590/[$500,590 - $40,800]}= 1.089. The annual sales figure is not necessary in the calculation of DFL. Additionally, remember that the DFL figure is always greater than one, therefore the first and fourth answers can be eliminated as possibilities by observation alone.

  Exam P